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February 22, 2010

The Monetarist Equation: Explaining The Crisis And Predicting the Future (Part 1 of 3)


Money Supply Times Velocity equals Price times Output (M X V= P X Q)

The monetarist equation, developed by economists like Milton Friedman, is used to explain how the major variables of the economy stay in balance:

M= Money Supply
While the definition of money supply has apparently changed (the Fed no longer counts M3 or L, which are less liquid versions of money). The money supply is now M1 (paper money) plus M2 (deposits, money market accts, etc). The Federal Reserve is supposed to control this variable to help stabilize the economy.

V= Money Velocity
Velocity, which is easily the least study variable in this equation, covers the speed at which money circulates the economy. A velocity of ‘2’ means that the average dollar circulates the economy twice in a year (or another given time).

P= Price
Prices, are the overall costs of goods and services by producers. Prices, for the purpose of the equation, cover a broad range of prices in the economy. Price hikes in certain areas will likely not be affected by this. This price variable is used to measure inflation and deflation.

Q= Output
Output is the value of all goods and services produced by an economy. GDP is the most popular and accurate measure of output. When GDP declines, we are considered to be in a recession. Output, in terms of our modern culture is the most important variable (of this equation) to our media and government.

M times V equals P times Q

This equation basically states that as long as the money supply and velocity remain stable (or prices and output), the economy remains stable. Quick changes, or shocks in one variable will make the economy unbalanced, lead to possible crisis, and dramatic changes on the other side of the equation. Now, let’s take this knowledge and apply it to the current economic situation, and try to determine what happened.

The Financial Crisis of 2008

There are several theories as to what brought on the crisis of 2008. Many, like unapplied regulations, cannot be tested with the monetarist equation. It is also apparent that multiple factors influenced the rise and fall of financial system. However, it appears that the availability of “easy money” can be applied to this equation, and explain quite a bit.

Process: Massive money supply increases (2001-2004), massive increases in velocity (2003-06)

So first, the money supply increased dramatically, and velocity followed when the economy began to stabilize as people invested, borrowed, and spent money more confidently. As a result, the other side of the equation had to follow. We saw unprecedented growth from 2004 through 2007, and finally prices, known as a “lagging indicator,” began to rise. Some areas had greater increases in prices (housing) than others, likely due to the fact that excessive amounts of money were pouring into the industry.

So, by using the monetarist equation, we can develop an explanation of the economic growth that occurred in the last cycle, so what caused this to stop? The beginning was the normalization of the money supply and velocity. Velocity slowed as prices went up, and demand began to taper in the hottest of economic areas. Prices in the hottest of areas (like housing) began to fall because the huge investments required to maintain those levels were now gone. Prices falling and velocity (which seems to move well in tandem with consumption) tapering meant that pressure began hit output (GDP).

Now, the economy was slowly moving into recession, but unfortunately, the bubbles that had burst in 2000 were transposed into the financial industries which carried a much greater exposure in the economic. As financial and investment institutions began to fail, the largest element of the crisis took hold, fear.

So, the stage is set for collapse. What happens next? Tune in on Wednesday as we discover the one variable in the equation that took on the biggest role, yet got the littlest amount of attention. We’ll examine what the government did, why it was wrong, and what I think we should have done.

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